# Newsletter March 8, 2006

**InvestorsFriend Inc. Newsletter March 8, 2006**

**Performance**

Please check out the continued excellent performance of our stock picks.

One of the things I really like about the work I do in picking stocks is that at any point after we pick a stock we know how we are doing. It may not be fair to expect the stock to move in the predicted direction right away, but certainly after say 12 months I would hope it has moved in the predicted direction.

I don’t have to depend on anyone’s judgment as to whether I did a good job or not. Either the stock picks have made a decent or better return over time or they have not.

Right now, I am pretty pumped because the market results clearly indicate that for the fourth year in a row the stock picks are making a very good return indeed. Even with the TSX itself up 6.3% in just two months this year, my personal investments are on track to beat the TSX for the seventh year since this Site was started.

In the past three years I have been fortunate enough to have personally made returns of a compounded 31% average per year. That return more than doubled my portfolio in three years (before any new contributions). This allowed my portfolio to reach a point where even a small percentage return starts to represent a noticeable amount of money. With compound returns the portfolio of any investor who starts saving by around the age of 40 or earlier should eventually grow to the point where even a small return results in a noticeable amount. Of course if one can achieve higher than average returns then the portfolio will become noticeably larger a lot sooner. I will have more to say about this below.

**Trust**

Some of you who are receiving this free newsletter may be interested receiving our stock picks, but you may be wondering if you can trust this Site. That is a reasonable question and apprehension. When it comes to looking for ideas on where to invest your money, having Trust in the source is clearly extremely important.

I have always felt that the quality and trustworthiness of this Site is abundantly self evident. Most of our paid subscribers first became familiar and comfortable with this free newsletter and our large library of educational articles before deciding that it was worth it to pay for the stock picks. However, some paid subscribers decided to subscribe immediately on becoming aware of this Site. I guess they felt that they had found a good thing and decided to act immediately, which is quite gratifying.

Speaking of the paid subscribers, I must say I could not ask for a better group of customers. For example, a number of monthly paid subscribers have been our customers continuously for over three years since I began the paid subscription service. Some subscribers pay by cheque and I have been delighted by the renewal rates. Some customers have even proactively sent in cheques even before their subscription had expired. And, the attrition rate of those that pay monthly through PayPal has been relatively low. I can only conclude that these excellent customers find good value in the stock rating service provided.

I fully realize that not everyone reading this free newsletter is in need of a stock picking service. Some of you are still trying to learn before committing money to stocks or otherwise are just not interested in investing in individual stocks. That is fine and I am very glad to have you as a reader of this free newsletter and as a visitor to the Site. Thank You.

If you are in the market for ideas on individual stocks to buy, then do consider subscribing to our stock picks. At some point all of my paid subscribers reached the point where they decided to take the plunge. If you are interested in the stock ratings service, then why not subscribe right now? In life I believe success comes from more often from action than from needless delay.

**Warren Buffett’s March 2006 Letter to His Shareholders.**

As you may be aware, Warren Buffett is at age 76 the second richest person in the world (after his younger friend Bill Gates whom he plays on-line bridge with) and he made his money by working for a short period in the investment industry (initially under the late Benjamin Graham – who virtually invested value investing). Warren saved his money and soon began to compound his wealth with smart stock picks. In 1965 he purchased a struggling textile company called Berkshire Hathaway. He turned Berkshire into a holding company which invested in common stocks and which bought other businesses. Today it is a huge conglomerate. The largest segment is insurance. The other three segments are regulated utilities, finance and financial products and a group called manufacturing, service and retailing. In addition there is an investing operation that holds common shares in other stocks and which lately has invested in a huge currency speculation against the U.S. dollar.

Each year since about 1966, Warren has hosted a folksy annual meeting at which he dispenses his business thinking and answers shareholder questions. In recent years around 20,000 people attend his annual meetings. I was there in 2003. A good number of those in attendance are older people who became multi-millionaires by investing a few thousand dollars in Berkshire in its earlier days.

Each year Warren also writes a lengthy and very informative letter to shareholders. These letters explain how Berkshire did during the year but more importantly explain Warren’s business and investment thinking. For example he often explains how insurance companies work. He also often provides important lessons in accounting.

Warren posted the latest of these valuable letters to the Berkshire Web Site this past Saturday. I consider this to be must-read material.

I have summarized here some of the points in the letter that particularly struck my interest.

Warren states that “calculations of intrinsic value, though all-important, are necessarily imprecise and often seriously wrong.”

In some ways this statement should be obvious since intrinsic value is a an estimate of the value of the cashflow a company will produce from now to infinity. However analysts, including myself have ways of estimating intrinsic value. Warren reminds us that our estimate is only as good as our assumptions and whether these assumptions turn out to be correct. Just because we calculate an intrinsic value in a spreadsheet does not mean the number is necessarily right. I always try to keep that in mind and it is one reason that I consider a number of factors in rating a stock. Also I attempt to make reasonably conservative estimates of intrinsic value. That way I will have an up-side if the company does better than I have assumed.

In talking about insurance numbers Warren indicates that when the insurance product itself simply breaks even, that gives him the opportunity to invest the money that is ear-marked to pay claims (reserves or float) at a cost of zero percent. When you consider that the Canadian property insurance companies that I have rated are making positive profits on insurance before investment gains and losses, Buffett’s statement illustrates that these Canadian property insurance companies are making unexpectedly large profits.

Buffett also gave an explanation of why giving stock options to executives is tantamount to rewarding mediocrity. Any company that retains some of its earnings will likely have an increase in its stock price over a four or five year period, because its book value will grow. Executives should get bonuses for better than market returns, not for achieving mediocrity.

You can check out the letters yourself at http://www.berkshirehathaway.com/letters/letters.html

By-the-way, notice that Berkshire’s web site is very plain with no graphics. People occasionally give me advice to jazz up the investorsfriend site. But as you can see I am in good company when I keep a plain but easy to navigate site.

**Some Surprising Investment Return Math**

It might surprise you to learn that when you first start investing, the return that you make is relatively unimportant. What is much more important at the early stages is the amount that you contribute annually.

It is true that if you invest a single lump sum and let it compound, then the returns in each year are equally important. That is, if you invest say $10,000 and lose 20% of that ($2,000) in the first year then this will have exactly the same impact on your final portfolio as would a 20% loss in year 10 or year 30 etc.

But realistically people do not invest a single lump sum, rather they usually begin investing at some point and then typically make an annual investment most years (often based on registered retirement savings plans and other tax-advantaged plans). Typically the amounts invested grow over time as individuals advance in their careers.

So… if you make or lose 20% that first year it would only affect your initial contribution as well as the future compounding of that initial contribution. However, if you make 20% or lose 20% in year 20, then this will affect the compounded level of your contributions that were made in each of the 20 years as well as the future compounding of each of those 20 sums. The result is that returns in later years matter a lot, while your returns in the early years will not matter much.

In the early yeas of a retirement savings plan, the annual contributions matter a lot and will tend to dwarf the impact of your returns. For example, If you begin by contributing $3000 per year a 10% gain on the first $3000 ($300) is dwarfed by the next year’s contribution of $3000. However, if you invest $3000 per year for 30 years at 10%, then in 30 years this will grow to $543,000 at which point a 10% gain ($54,300) will dwarf your $3000 annual contribution.

I calculated that a loss of 10% in year 1 (rather than gain of 10%) will affect the portfolio value in year 30 by just 2% (because it has no impact on the contributions after year 1). Meanwhile a loss of 10% in year 30 (rather than a gain of 10%) will affect the portfolio by 22%! (because it impacts the contributions from each year).

In the early years the most important thing is to make regular contributions to savings, the returns in those early years while important will tend to be dwarfed by the impacts of the annual contributions of new money.

In later years, the returns become much more important than the annual contributions. At some point if you can build up say a $500,000 portfolio, then a 10% return will be $50,000. At that point, your annual contribution may be totally dwarfed by the return on the portfolio. In fact, the portfolio could become almost self sustaining. At some point if the portfolio is very large compared to your ability to make annual contributions then it will hardly matter if you even make annual contributions anymore. If this point can be reached before retirement age then this is a very nice situation to be in.

The above analysis also leads to the conclusion that high risks can be taken in the early years. If you swing for the fences in the early years and strike out, it won’t matter that much because the contributions of subsequent years will dwarf a small initial loss.

In later years risk and reward both have a tremendous impact. On a very large portfolio of $1,000,000, a 20% loss is a huge $200,000 which for most people would be almost impossible to ever make up in annual contributions. On the other hand a gain of 20% on a $1,000,000 portfolio is also a huge $200,000. For most people the pain of losing $200,000 would be huge and it is just not worth taking big chances once a very large portfolio like $1,000,000 has been painstakingly built up. Swinging for the fences could be a huge mistake at that point.

**END**